Inversely Related Variables in Economics - Essay Example

ECONOMICS ANSWER The functioning of the firms in the real world can be expressed in economic models. Economic theories categorize the market structure in to four models namely perfect competition, monopolistic competition, oligopoly and monopoly. In economics, a model refers to the representation of economic system by set of variables and its logical or quantitative relations. Economic model takes either the form of a diagram or a set of equations that set out the relationship between different variables. According to traditional economic theories the firms try to maximize profit, growth or sales, but the modern theories predict the firms will try to manage profit and sales or growth. This is known as satisficing. If the firm wants to maximize its profits it will try to equate marginal revenue and marginal cost. Marginal cost refers to the increase in the total costs of a firm caused by increasing its output by one extra unit. From the viewpoint of economists, firms normally produce at a point at which the marginal costs are positive. Marginal revenue refers to the receipt from selling an extra unit of output. On the other hand, when the firms go for satisficing the managers of a firm need to make enough profit in order to satisfy the demands of their shareholders. Satisficing or profit satisficing denotes the managerial behavior that attempts to achieve some level profits. Once the satisfactory level of profits has been achieved, the managers are free to maximize their rewards that can be available from the particular company. All the markets are in equilibrium when the demand and supply are equal. Equilibrium or equilibrium price refers to the price level of a particular commodity at which quantity demanded equals quantity supplied. Here the price and quantity demanded are having a negative relation. The variables which are negatively related, for example price and quantity demanded, have an inverse relation. Here the price is a determinant and the quantity is determined. An increase in the price leads to a fall in the quantity demanded and vice versa. There are many inversely related variables in economics, for example rate of interest and borrowing, economic growth and balance of payment, unemployment and inflation etc, that is an increase in the rate of interest, an increase in the economic growth and an increase in the unemployment will cause a fall in borrowing, balance of payment and unemployment respectively. The actual market always tends towards the equilibrium price where demand and supply curves cut each other. For example, the normal price of rice in a market is $ 8 per kg. Suppose there is neither excess demand nor excess supply of the rice, the quantity demanded and quantity supplied will be equal. The price determined like this is known as the market price. This market price might be changing according to the fluctuations in the market. This tendency of increasing the price level is known as inflation. But, due inflation, some time the values measured may not give exact changes of neither decrease nor increase unless it is adjusted to the inflation. The values that are adjusted for inflation can be termed as Real value. In any economy housing market is an important factor that determines the growth. The house prices and consumer confidence are directly related. The house price index shows the health of the economy. In USA, Housing Market Index (HMI) and NAHB Housing Market Index are significant. In economics, index refers to the number which is calculated from quantities or prices. Index is an indicator showing the relative value of one number to another from a base of 100. It is often used to present an average of a number of statistics’ (Alain Anderton 2003). Normally index numbers are calculated for prices and production like retail price index or cost of living index etc. Prices of the commodity or service included in the index can be recorded in the current period and divided by its price in the base period so that a price relative can be obtained. ‘An index number merely expresses the value of some series in any given period as a percentage of its value in the base period’. (R.G. Lipsey and A. Christal 2007) The fluctuations in the market cause trouble for consumers and producers. One of the main sources of this fluctuation is the price elastic demand and supply. If the market left free, it will automatically adjust, that is the price mechanism will provide incentive, signaling and ration the resources. The main resources in the economy are factors of production that is the land, labour, capital and organization. Economist calls land to the fertile soil vital to the growth of plants, mineral such as coal and oil and animals for their meat and skin. To the economics, land includes all natural resources that are used in the production process. Everything from gold deposits to rainwater and natural forests are example of land. Land is different from other factors of production namely capital, entrepreneurship and labour in the way that land’s supply is more or less fixed. Capital consists of the machines, factories, offices, roads, plant and building that make production possible. Though capital refers to the assets capable of generating income it does not include raw materials used for production process. The process of producing and purchasing capital goods is known as investment. Capital goods are different from consumer goods in the way that consumer goods satisfy human wants and needs directly while capital goods satisfy them indirectly. The ‘term’ capital does not mean ‘money’. According to economists, money does not produce any thing and hence it is not an economic resource. The stock of capital in an economy necessarily needs to increase if economic growth is to be gained. There should be sustained investment in the economy in order to achieve better economic development. Normally, a business firm has to assess whether the capital investment results in any extra revenue so as to take a decision on investment. There are free goods and economic goods. Free goods are those goods that are having no opportunity costs, while economic goods have it. Resources are scarce but human wants are infinite is the basic economic problem. It forces to make choices. Economic agents have to allocate their scarce resources among alternative uses. Every choice involves many alternatives. For example, a particular government has $ 10 billion that can be either used for building bridges or for constructing more school buildings or for creating more social care to the public. This basic problem can be seen from every consumer as he may have only $ 10 but has three wants of buying a note book, buying a pen and buying a dress. He can utilize this $ 10 only for one use and the rest two will be given up. Here the obvious basic economic problem lies is that resources are scarce and human needs and wants are unlimited. When the market fails to allocate the resources the government might intervene. Subsidies, buffer stocks, minimum and maximum prices are some of those. Subsidy is a grant and buffer stock is a combination of minimum and maximum price. Minimum price aims at producers and the maximum price aims at consumers. ANSWER - 2 Efficiency comparison Imperfect competition refers to the market structure where there are entry barriers, imperfect information, less number of producers and differential products. Monopolistic competition, oligopoly, duopoly are some of the examples. Using these theories we can analyze the behavior pattern of the firms. Pricing and output decisions under monopolistic competition Monopolistic competition is a market structure where there are large numbers of producers producing differentiated products and there are low levels of entry and exit barriers. Under the monopolistic competition the firms are independent that is the market share of individual firm will be insignificant compared to the industry as a whole. Street cafes, saloons, automobile servicing are some of the examples of monopolistically competitive firms from the real world. Since there are many firms, more will be the number of substitutes leading to an elastic demand curve, however since there is certain degrees of differentiation exists the firm will be free to decide the price and output individually as shown in the diagram below. A saloon will be in equilibrium when MC= MR. In the short run, the Saloon can make profit, loss or normal profit depending upon the position of Average Cost curve. However, in the long run, it is assumed since there are many rival saloons and low levels of entry and exit barriers all the saloons will be making the normal profit, that is LRAC= AR. The equilibrium of a saloon is shown in the diagram. It is in equilibrium when MR=MC. OQ is the level of production and OP is the price. How ever, if the saloon were operating in a perfectly competitive market the equilibrium will be at the point where the demand (AR) and supply (MC) equals. More would be the output and less would be the price. The efficiency of the resource allocation and welfare of a firm under the monopolistically competitive market and of the perfectively competitive market can be analyzed with the help of the consumer and producer surplus. Under the perfect competition the consumer surplus can be represented by area 1+ 2+ 3+ 4+ 5 and the producer surplus by the area 6+7+8. Under the perfectly competitive condition, the firm will be in equilibrium at the minimum point of long run average cost and the resource allocation would be efficient because, at that point price and marginal costs will be equal. But under the monopolistic competition, the consumer surplus reduces to the area 1+2 and the saloon operates at the downward sloping position of the long run average cost. It shows the firm is productively inefficient and since the price is not equal to the MC the firm is allocatively inefficient too. ANSWER- 3 Equilibrium Diagram The diagram below shows the demand and supply curves of apartments in a city. At point ‘e’ the demand and supply are exactly equal, or the equilibrium is achieved. At the point of equilibrium the quantity demanded and supplied of apartments is 80 and the price of apartments is £140000. Price elasticity of demand Price elasticity of the demand can be calculated by the formula Original quantity = 100 New quantity = 90 % change in quantity demanded = (90 – 100)/ (100* 100) = - 10 Original price = £100,000 New price = £ 120,000 % change in price = (120,000 – 100,000)/ (100,000*100) = 20 PED = -10/ 20 = - 0.5 Factors that determine price elasticity of demand a. The number and closeness of the substitutes of apartments. Apartments have got substitutes like rented accommodation flats and owner occupied houses. The more is the availability of these substitutes the Price elasticity of demand of the apartment tends to be elastic and vice versa. b. The period of time. Price elasticity tends to be greater over long run because consumers have more time to adjust their behavior towards apartments and to find other options c. The proportion of the income spent. If the proportion of the income spent on a commodity is more, the demand for the commodity tends to be elastic. The apartments are expensive and usually take a greater percentage of income so if the prices increase the burden on the consumers will be more and the demand will fall more than proportionately and vice versa. Market adjustment The market for apartments is shown in the diagram below. The price is £ 800000 and the quantity demanded is 110 and the quantity supplied is 110. There is an excess demand or shortage of 90 apartments. It is shown by ‘a’ - ‘b’. This excess demand will lead to a competition to the consumers and the efficient consumers will be ready to offer more prices. An increase in the price will encourage the producers to supply more apartments and producers will move from point ‘a’ to point ‘e’ as the consumer keeps on offering more and more prices and moving from point ‘b’ to ‘e’. At point ‘e’, both demand and supply are equal and the market regains equilibrium. Scheme 1 - Maximum price Maximum price refers to the setting of a price ceiling by the government to control the price of apartments from further rising If the government sets a maximum price of £ 100,000 on the apartments, it will be having an effect as shown in the diagram above. This leads to an excess demand for apartments. Such a scheme by the government might lead to more demand and the government has to provide housing directly or encourage the apartment builders to build more and more houses. However, since the price is caped it will be very difficult for the producers to increase the supply of their apartments. This may not solve the shortage of apartments that resulted from the maximum price. Scheme 2 - Subsidy Subsidy is a grant given by the government to the producers. The government is giving a subsidy of £ 50,000 on each new apartment payable to the builders, the actual production costs fall this fall in the cost of production leads to a rightward parallel shift in the supply curve leading to a change in the equilibrium from ‘e’ to ‘e 1’. As a result, the price falls from £140,000 to £ 110,000. The total number of apartments traded increases from 80 to 100. However, when the subsidy is given it is noted that the full amount of subsidy is not reflected in price. Price falls by less than the amount of subsidy. The major concern when the government dolls out the subsidy is the cost of subsidy. Usually, the resource for subsidy is imposed from the taxation. This might lead to an increase in the tax burden on the people and might lead to some adverse macro economic impacts. In the case of imposing a maximum price the immediate government expenditure is relatively low compared to that of subsidy. The maximum prices will solve the problem of apartment market to some extent but it will fail to encourage the producers to supply more. If there is a shortage the government has to find out some alternative methods. On the other hand the subsidy will increase the supply leading to a fall in the prices and the affordability might increase. However, if the producers catch all the subsidies and do not increase the supply, the subsidies also might turn ineffective. References ALAIN ANDERTON (2003), Economics, Third Edition, Cuaseway Press Ltd CAMPBELL R. McConnell & STANLEY L. BRUE (2004), Economics: Principles, Problems, and Policies, McGraw-Hill Professional DAN MOYNIHAN & BRIAN TITLEY (2000), Economics A Complete Course, Third Edition, Oxford University Press RICHARD G LIPSEY & ALEC CHRYSTAL (2007) Economics, Eleventh Edition, Oxford University Press WALTER J WESSELS (2006), Economics, Fourth Edition, Barrons Educational Series Read More